Revving up with REITs

Use real estate to diversify regardless of cycle

SAN FRANCISCO (CBS.MW) -- Real estate investment trusts have gained in popularity over the past few years as plunging interest rates caused investors to chase higher yields and relative stability.

Even now, with rates on the rise and growth in the sector slowing, REITs can still play a vital role in the average investor's nest egg.

"There's always a place in someone's portfolio for real estate because of the broad diversification that it provides as well as its ability to generate high levels of income," said Jack McAllister, vice president for investment affairs at the National Association of Real Estate Investment Trusts (NAREIT).

A REIT owns and typically operates income-producing properties or, in some cases, provides mortgage financing. Occasionally a REIT covers both areas -- these are known as hybrids.

To qualify as a REIT, the company must distribute at least 90 percent of its taxable income in the form of dividends to shareholders. In exchange, a REIT receives favorable tax breaks.

There are about 180 publicly traded domestic REITs with assets of approximately $375 billion, according to NAREIT. REITs tend to fall into four categories: retail, office, residential and industrial.

Tide turns

REITs have enjoyed a nice run in the last few years, but muted interest this week in the initial public offering of Ashford Hospitality Trust could be a sign of the public's reluctance to continue to buy up REIT shares in the current environment.

Ashford Hospitality
AHT, +1.57%
which invests in hotels like Radisson and Embassy Suites, priced its initial public offering at the low end of its expected range and also pared the size of the deal by more than a third.

Shares managed a slight advance from the $9 pricing, trading as high as $9.30 on Friday.

Separately, U.S. Bancorp Piper Jaffray analyst Andrew Rosivach pointed to a tightening spread between investment-grade corporate bond and REIT yields as the primary factor in his recent sector downgrade.

"When current multiples stop making sense," he wrote in a report to clients, "we believe the only REITs that can work are those that can provide material earnings growth."

Strong performance

Historically, REITs have performed favorably compared to stocks and bonds. As a group, they've returned 12.2 percent annually from 1972 to the end of 2002, versus 10.9 percent for large-cap stocks and 13.9 percent for small-cap stocks, according to Ibbotson Associates. Bonds have returned 9.2 percent.

At the same time, the study showed that the correlation between REITs and other investments has declined over that time frame, suggesting that REITs can serve as an integral part in optimizing a diversified portfolio.

"While stocks have been down significantly in the past three years, bonds and real estate have been up," said McAllister. "That's perhaps the best real-world example of why investors with long term horizons really ought to have real estate in their portfolio."

Crunching the numbers further supports the idea that REITs aren't necessarily tied to stock market fluctuations. In 2000, the Nasdaq plummeted almost 40 percent while the NAREIT Composite, including reinvested dividends, jumped more than 25 percent.

The dividend tax cut that was enacted this year, and the talk of such a cut that went on previously, may have lured uninformed investors to REITs during their strong run. But unlike regular stock dividends that will now be taxed at 15 percent, most REIT dividends were excluded from the tax bill and are taxed as ordinary income.

For that reason, Watkins recommends that, in many cases, these funds be used in a tax-advantaged retirement account.

The consensus among market watchers, bolstered by Ibbotson's research model, seems to be that between 15 percent and 20 percent of assets should be allocated to the real estate market to maximize returns and minimize risks.

"REITs are the natural way to bring large-scale real estate into publicly traded portfolios for the average investor," McAllister said.

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